Disclaimer:
The speaker, Professor Rajan, emphasizes that his lecture is not a policy statement and has no bearing on real-world policies. It’s a way of thinking about the real world, not a reflection of actual policies.

Introduction:
Professor Rajan revisits the topic of why banks have a peculiar structure of receiving demandable deposits that can be withdrawn at any moment while funding longer-term investments.

Efficiency of Demand Deposits:
Banks issuing demand deposits is an efficient form of borrowing. Demand deposits keep bankers accountable and on the straight and narrow, ensuring responsible investment decisions. Unlike equity contracts, demand deposits provide depositors with the right to withdraw their money anytime, giving them control over their funds.

Comparison with Equity Contracts:
An equity contract in which you hold equity in an individual or firm allows no questions or expectations for dividends until the holder is ready to pay. Demand deposits, on the other hand, give depositors the right to withdraw their money whenever they want, which offers more control and flexibility.

Benefits of Demand Deposits:
Demand deposits allow bankers to raise money at a lower cost and perhaps more money than they could with equity claims. Demand deposits provide depositors with control over their funds, encouraging them to trust and invest in banks.

Benefits of Equity Claims:
While demand deposits are cost-effective, having some equity claims in a bank’s capital structure provides buffering against adverse shocks. Equity claims absorb the impact of asset value declines, protecting depositors from potential losses.

Introduction:
Professor Raghuram Rajan sets the stage for discussing the concept of general equilibrium in economic systems, emphasizing the interconnectedness of actions and the need to consider interactions and reactions when making policy decisions.

Definition of General Equilibrium:
General equilibrium is a concept that recognizes the interconnectedness of actions and reactions within an economic system. It suggests that an action cannot be judged in isolation but must be evaluated in light of how other players, prices, and quantities react.

Example of Car Licensing:
Rajan illustrates the concept using the example of car licensing. Making the car license stricter may not necessarily lead to better drivers on the road. This is because individuals may find ways to circumvent the licensing process, rendering the policy ineffective.

Example of Seatbelts:
Rajan cites Sam Peltzman’s research on seatbelts as another example of general equilibrium consequences. While seatbelts generally make driving safer, their introduction and the requirement to wear them led to an increase in car accidents and damage.

Explanation:
This phenomenon occurs because wearing a seatbelt instills a sense of safety, leading drivers to drive more aggressively and engage in riskier behaviors, resulting in more accidents.

Application to Banking:
Rajan intends to incorporate the concept of general equilibrium into the analysis of banking systems, considering the interactions between banks, customers, and the uncertain economic environment.

Banks and Liquidity:
Banks structure with demand deposits, allowing individual liquidity problems to be solved through borrowing from other depositors. A general liquidity shortage in the system poses a challenge, potentially leading to a crisis for banks and entities with long-term assets and short-term liabilities.

Two Responses to Crisis:
Bailouts: Involves providing adequate funds to institutions, potentially reducing some debt to help them pay debt holders. Can be a generalized bailout for multiple institutions. Interest Rate Cuts: Reducing interest rates in the system creates solvency and helps address liquidity problems. Restores stability to the financial system.

Monetary Policy in Crisis:
Cutting interest rates sharply in the face of a crisis is an effective action by central banks. Monetary policy can help restore stability to the financial system impacted by crisis.

Monetary Policy as a Preferred Bailout Method:
Interest rate cuts, a form of accommodative monetary policy, are often used to bail out financial institutions during crises. This approach is preferred over individual bailouts because it provides a system-wide boost without focusing on specific banks. However, this policy comes at a cost, as certain segments of the saving population essentially subsidize the bailout by experiencing lower returns on their savings.

Anticipated Bailouts and Moral Hazard:
Anticipating monetary policy bailouts, banks may engage in excessive leverage and invest in illiquid projects. This moral hazard arises because banks know that the central bank will likely intervene by cutting interest rates to prevent a systemic crisis.

Mitigating Moral Hazard:
To offset the moral hazard created by anticipated bailouts, monetary authorities can take steps to discourage excessive risk-taking by banks. One approach is to raise capital requirements, making banks hold more equity relative to their assets. Another measure is to use macroprudential policies, such as limits on loan-to-value ratios, to reduce excessive borrowing and lending.

Conclusion:
Raghuram Rajan argues that interest rate policy can be an effective tool for addressing financial crises but highlights the costs and moral hazard risks associated with this approach. He proposes measures to mitigate these risks, such as raising capital requirements and implementing macroprudential policies, to ensure a more stable and resilient financial system.

Interest Rates and Consumption:
In a model with households that consume at two dates, those with higher income at the second date (high income households) consume more at the first date than those with lower income at the second date (low income households). This is because high income households want to smooth their consumption across dates, leading to higher demand for goods at the first date.

Interest Rates and Income Growth:
In the model, interest rates are determined by the number of high income households. As the number of high income households increases, the interest rate increases. This is because the higher consumption growth of high income households requires a higher interest rate to attract savings from depositors.

Asset Side of the Model:
Entrepreneurs borrow from banks to finance projects that require a unit input at date zero to produce cash flows at date two. These projects are illiquid, meaning that if liquidated at date one, they yield less cash flow than if held until date two.

Changes in Notation:
The notation used in the paper differs slightly from that used in the first paper on the same subject. This is due to the fact that the paper was written 12 years after the first one, and the authors did not pay attention to notation consistency.

Bank’s Special Abilities:
Banks can collect gamma Y2 from borrowers at date two or liquidate X1 at date one, while ordinary investors can only collect X2. Banks have special information and knowledge that allows them to collect more than X1.

Commitment Problem:
Banks can threaten to not collect as yesterday, promising depositors only x1. Depositors discipline banks through the threat of a run, forcing banks to commit to collecting the entire cash flow and passing it on to depositors.

Bank’s Decision:
Banks compete for depositors and promise the highest amount possible given asset side parameters. Nash equilibria determine the optimal deposit rate.

Timeline of the Model:
Households invest one each in banks in return for a promised payment of D at date one. Banks lend to entrepreneurs. At date one, the state of the world is revealed, affecting interest rates. Households decide whether to withdraw or stay in. The bank chooses which loans to liquidate to meet depositors’ demand for liquidity. At date two, projects mature, loans are repaid, and deposits are fully withdrawn.

Bank Runs:
High demand for liquidity can lead to bank insolvency and a full run. Bank runs are costly and inefficient, liquidating even good projects. Only a fraction of depositors get their money back, leading to insufficient risk sharing.

Banker’s Response:
Bankers anticipate the risk of runs and adjust their deposit rates accordingly. In states with a higher probability of strong consumption growth, bankers set a lower D to buffer themselves against liquidity stress. Bankers react to the expected interest rate picture at date one to choose the optimal capital structure.

Externalities and Central Planner:
There are no externalities in the model, and banks optimally set D. A central planner may consider intervention to address bank runs, but it would be challenging in the given structure of banking.

State Contingent Demand Deposits:
State contingent demand deposits tailor the deposit contract to the degree of optimism of households, having a lower D in optimistic states and a higher D in pessimistic states.

Verification and Transaction Costs:
Verifying the state of the world and alerting depositors about changes in the value of demand deposits takes time and incurs transaction costs.

Front-Running and Fragility:
If depositors know there will be a significant change in their deposit due to a change in the state, they may try to front-run the change by withdrawing their deposits early, precipitating the very runs that the state contingency was intended to avoid.

Distinguishing Households Based on Endowment:
It is difficult to design demand deposits that can distinguish between households with different endowments once they learn their endowment. In this model, it is impossible to do so.

Bailouts and Moral Hazard:
Central planners may intervene to prevent bank runs by taxing households and providing funds to banks. However, this approach faces challenges due to moral hazard. Knowing that bailouts are available, banks may strategically default to extract rents from depositors and the government.

Strategic Default and Ineffective Bailouts:
Strategic default occurs when banks refuse to pay depositors even when they have the ability to do so. Bailouts incentivize strategic default as banks can hold out for higher rents. The anticipation of bailouts can lead to increased leverage and higher deposit rates. As a result, bailouts may be ineffective in resolving insolvency and may even worsen the situation.

Reducing Interest Rates as an Alternative:
Instead of direct bank bailouts, monetary policy can be used to reduce interest rates. Lower interest rates can help banks by increasing the value of their assets. However, reducing interest rates also involves a bailout, as it benefits those who enjoy higher interest rates at the expense of those who would have received higher rates.

Challenges in Reducing Interest Rates:
Reducing interest rates is challenging because they are determined by consumer preferences. Central banks must carefully consider the implications of their actions and the potential unintended consequences of reducing interest rates.

Interest Rates and Borrowing:
Simply borrowing and lending does not change real interest rates. Depositors can offset government borrowing by withdrawing from banks, maintaining their consumption profile.

Ricardian Equivalence:
Households try to undo government actions, including borrowing and fiscal spending. Households can invest less to maintain consumption, countering government borrowing.

Creating Interest Rate Action:
Interest rate action occurs when depositors fully withdraw, leaving only those willing to accept lower rates. The marginal interest rate is determined by these remaining depositors. Quantitative easing can achieve this outcome by pushing down interest rates in high-rate states.

Central Bank Intervention:
Central bank intervention can bail out banks by pushing down interest rates. This restores state contingency and reduces rigidity caused by short-term liabilities and leverage. Intervening bank by bank allows the banker to extract rents, making it a less effective approach.

Exposed Central Bank Intervention and Moral Hazard:
Excessive central bank intervention can create moral hazard among banks. Knowing that the central bank will reduce interest rates to bail out banks in times of high-interest rates, banks may take on excessive leverage or invest in illiquid assets.

Illiquidity and Moral Hazard:
Illiquid assets become more attractive when central banks impose a ceiling on interest rates. Banks may choose to increase their holdings of illiquid assets instead of taking on more leverage, creating similar incentives and risks.

Implications for Regulation:
Exposed central bank intervention strengthens the case for regulating banks upfront, such as through capital requirements. However, if capital requirements are ineffective, it is challenging to change bank incentives.

The Dilemma of Central Bankers:
Central bankers often cannot stand by and watch the banking system fail, which leads them to reduce interest rates and provide liquidity in times of crisis.

Alternative Approach:
To discourage banks from taking on excessive leverage or investing in illiquid assets, central banks could raise interest rates a little faster in normal times.

Framework for Mitigating Banking System Stress:
Monetary policy can be employed to address banking system stress, but it can create adverse incentives for banks, such as excessive risk-taking and leverage. To offset these negative incentives, central banks can commit to raising interest rates more rapidly when the economy normalizes, essentially counteracting the implied put option granted to banks through monetary intervention.

Managing Fragility in Banking Structures:
Banks’ fragile capital structures are not anomalies but intentional design features, allowing them to offer higher payouts, lower financing costs, and increased economic financing. During liquidity shortages, central bank bailouts can soften constraints for bankers, leading to rent extraction and worsening the system’s condition. Higher capital requirements can limit banking failures, but they also raise financing costs and potentially curb banking activity.

Banking System Stress and Monetary Policy:
Monetary policy can be an effective tool for addressing banking system stress, but it can lead to adverse incentives for banks. To counter these negative incentives, central banks can rapidly cut interest rates to alleviate stress and then raise them more quickly as the economy recovers, thus offsetting the initial intervention. This approach assumes that central banks prioritize managing banking crises over controlling inflation.

Conclusion:
Banks’ fragile structures are inherent to their ability to provide higher payouts and lower financing costs, promoting economic financing. Monetary policy can be used to address banking system stress, but it can create adverse incentives for banks. To offset these incentives, central banks can commit to raising interest rates more rapidly as the economy normalizes.